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Ford Motor Company, General Motors, and the other major automakers have done well over the last five years, but will it last? Here are some tools to better gauge the health of the auto industry.

General Motors' iconic Renaissance building in Detroit. Source: General Motors.

To put it bluntly, the automotive industry can be a scary investment for your hard-earned money. Investors that have been putting money into the market for more than a decade remember the horrible mismanagement that brought Detroit automakers Ford Motor Company(NYSE:F), General Motors(NYSE:GM) and Fiat Chrysler Automobiles(NASDAQOTH:FIATY) to their knees. Investors new to the market are likely already hesitant to invest in automakers after witnessing General Motors'recall debacle this year, which now amounts to 30 individual recalls covering 13.8 million vehicles and threatens to wipe away roughly $1.7 billion in GM's profits. Furthermore, most investors are simply wary of the automotive industry's vicious cyclical nature.

With all of that said, this article's purpose is to give potential investors some tools to better gauge the health of the automotive industry.

10,000 foot view Let's start with one of the most-used terms in the automotive industry: seasonally adjusted annual rate, or SAAR. This is how the industry uses monthly sales and extrapolates the result into an annual pace.

Graph by author. Source: Automotive News DataCenter.

As you can see, after the recession and ensuing crash of vehicle sales, the industry has posted very consistent and stable growth. This is a great way to judge the trending sales of the entire automotive industry in the U.S. market, but SAAR alone doesn't tell the full story. To better gauge the overall health of the automotive industry, we need to dig deeper.

Vehicle sales can be inflated over periods of time when automakers push massive incentives and cash deals to help move cars off their dealerships in an attempt to grab market share from competitors and boost company revenue -- though the boosted revenue comes at a detriment to margins and profitability. Before and during the recession, automakers had too much inventory, and when vehicle demand plummeted, it took massive incentives to sell vehicles. We know how badly that ended for the automotive industry; investors would be wise to keep an eye on incentives per vehicle.

As you can see, incentives have been held in check by automakers since the recession, which is creating a more profitable environment automakers. Another measure that goes hand in hand with incentives is Average Transaction Prices (ATP). This simply measures how much each retail vehicle is selling for, on average.

The trends above suggest a very positive scenario. As incentives have remained stable, or slightly declined, ATPs have risen which suggests demand for new vehicles is outpacing supply, currently. Lower incentives and higher ATPs is also a result of additional new vehicles being launched in the market, suggesting automakers are much healthier and can invest in capital intensive production, R&D, and marketing.

To take it a step further, you can take the average incentive divided by the average transaction price. The trend investors want to see is a smaller percentage of incentives per transaction prices over time. Investors should consider it a red flag if incentives spike while prices decline over time, sending the incentive percentage of ATP higher.

As you can see, that isn't the case, and the incentive percentage of ATP has fallen and remained stable. All of the factors discussed above appear very positive for the health of the automotive industry, currently. The automotive industry's sales have grown at a stable and consistent pace since the recession, and automakers are needing less cash deals to sell more expensive vehicles -- making a very healthy market for automakers.

Looking ahead These graphs and measures are all valuable, but how can we better understand where the industry is going from here?

Without a magic crystal ball, no one can say for sure. One indicator to keep an eye on is the average age of vehicles on the road. Consider that in 1995, the average vehicle on the road was 8.4 years old, according to R.L. Polk & Co. It now sits at a record high of 11.4 years as car buyers postponed new vehicle purchases during and after the recent recession.

As the average vehicle remains at a record high, it suggests that automotive-industry sales have yet to peak in this cycle; when more new vehicles replace older vehicles and we see the average age of vehicles begin to decline, it will warrant a closer look. As usual, there's more to consider here.

Many investors keep an eye on the average age of vehicles, but they often don't consider the back end, which actually drives demand: vehicle scrap rates. Cars don't drive forever, and at what point does a vehicle's life end, removing supply and increasing demand in the auto industry?

Looking at research from Itay Michaeli, head of auto research for Citi Investment Research & Analysis, it shows that vehicles are scrapped at a much higher rate beginning at 13 years of age. That means the average vehicle on the road, at 11.4 years of age, is about a year and a half away from being scrapped at a much higher rate, which would spur even more new vehicle sales. That suggests a healthy automotive industry in the coming years.

Bottom line As previously said, the automotive industry can be a scary place for investments, but these graphs and metrics should give investors some tools to understand where the auto industry is in terms of stability, overall health and profitability, as well as potential demand in the coming years.

Author

As a Motley Fool Industrial Specialist, I use my marketing and business background in the automotive industry to evaluate major automakers and other large industrial corporations. Follow me on twitter for tweets about stocks, cars, sports, and anything I find amusing.
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